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The Wealth Strategies Journal has posted a new article by Richard Harris, entitled “Borrowing to Finance Life Insurance Premiums: What Professionals Need to Know.” In his article, Mr. Harris discusses the advantages and disadvantages of purchasing life insurance with “premium financing.” In this model, an individual establishes an Irrevocable Life Insurance Trust (“ILIT”) to borrow funds, purchase a life insurance policy, and own the purchased policy. The ILIT becomes borrower, policy owner, and policy beneficiary in a series of transactions sold under the guise of attaining “free” life insurance. This concept, which is often practiced today, is not well-vetted for many estate planning practitioners.

In his article, Mr. Harris considers the various aspects of this arrangement and their unique application to ILITs. The ILIT will borrow money each year to pay the life insurance premiums for that year. The interest rate charged on those loans will fluctuate with the market rates, typically determined by the London InterBank Offer Rate (LIBOR). Whether the interest payments are paid annually or accrued is determined by the trustee, who should be the original applicant and “owner” of the policy. If the trustee decides to pay the interest annually, then gifts will have to be paid to the ILIT as the ILIT, for all intents and purposes, is the borrower. These gifts are liable for taxation under the Internal Revenue Code, so the practitioner should advise his client of the necessity of proper gift planning.

The ILIT may make payments on the principal depending on the provisions of the loan agreement. These loans are usually collateralized with a combination of the cash surrender value of the life insurance policy and “stand-by” collateral provided by the guarantor. The latter collateral will come into play only where the cash surrender value of the policy is insufficient to meet the debt obligation. In the rare case that the lender will call the loan, the guarantor may have to make payments on behalf of the ILIT. In this case, the repayment of the loan principal by the guarantor will give rise to gift tax liability on the part of that individual.

Life insurance is a complex financial tool. The type of policy considered best for the purposes of “premium financing” is Equity Indexed Universal Life Insurance (EIUL). Given the complexity of this specific vehicle, Mr. Harris recommends purchasing an insurance policy with a rate of return between 5% and 6.5%.

Apart from these technical aspects regarding “premium financing” and life insurance policies, Mr. Harris shares eight practical lessons from his experience in the field. Most individuals who are sold on the “premium financing” model do so for the benefits of getting “free” life insurance. However, the true consequences can sometimes be very sticky. To avoid this, Mr. Harris’s overarching advice is for the estate planning practitioner to avoid becoming trapped by the sales pitch of an insurance salesman, who oftentimes only quotes an overly-optimistic estimate of their product’s performance.

To read Mr. Harris’s great article including his eight lessons, click here.